The financial crisis has produced no shortage of culprits—from Wall Street executives who were highly compensated for taking excessive risks to woefully undercapitalized insurance companies. Then there are the so-called credit rating organizations, or CROs, which have largely flown under the radar. How was it possible that CROs such as Moody’s and Standard & Poor’s handed out so many high-quality ratings to investment vehicles that turned out to be so high-risk?
Regulators have long viewed CROs as financial gate keepers and counted on them to provide investors with impartial assessments of companies’ creditworthiness or pools of assets. As a result, some institutions have relied on CRO ratings instead of due diligence.
Academics have been calling for rating organization reforms for years, and their calls became more urgent after the housing crash. When foreclosures began to mount in 2006, CROs at first did nothing. Then, on July 10, 2007, the nation’s two largest CROs downgraded $20 billion of subprime mortgage- backed securities, causing enormous losses throughout the financial system. A month later, the Securities and Exchange Commission (SEC) launched a formal investigation of the CROs.
In its 2008 report, the SEC described CROs’ failings in detail. Among the most glaring deficiencies reported was that none of the leading CROs kept specific, comprehensive written procedures for rating subprime mortgage-backed securities and the structured investment vehicles known as collateralized debt obligations. At the same time, CROs’ internal emails suggested they were rating deals that their analysts thought should not be rated.
Today, calls for reform are leading to regulatory proposals, including one that would create an SEC office dedicated to CRO oversight. These proposals tend to focus on five areas:
- ending regulatory reliance on CROs
- ensuring that CROs provide new disclosures
- increasing competition
- reducing conflicts of interest
- ensuring that CROs establish adequate internal controls
Ending Regulatory Reliance on Credit Ratings
Government supervisors use ratings to limit the types of assets regulated institutions can hold. As it stands, CROs are effectively government-sanctioned gatekeepers, creating a market for credit ratings sometimes regardless of their quality. At the same time, it is hard to unwind the extensive regulatory reliance on credit ratings, which are referenced in scores of statutes, regulations, and interpretive letters.
One way to encourage long-term reform on this front would be to give a government supervisor the mandate to work toward ending regulatory reliance on CRO ratings, building on the decades of research already conducted.
Providing New Disclosures
In the past, CROs were forthcoming about their credit rating methodologies and how traditional ratings (such as those for corporate bonds) differ from structured ratings (such as those for asset-backed securities). The assumptions underlying those methodologies, however, have not been available to the investing public. Moreover, the difference between structured products and traditional corporate bonds is not captured in the ratings symbols. For instance, both corporate bonds and mortgage-backed securities can be rated AAA (or Aaa), but their risk characteristics are materially different.
Those are conspicuous omissions. To fully inform ratings users, it is necessary to disclose underlying assumptions, especially the likelihood of a default and the loss it would cause. Adopting new symbols for structured products would signal that these products differ from traditional ones. The new symbols would also make structured products ineligible for satisfying many regulatory requirements that are based on traditional “investment grade” symbols.
The CRO market is heavily concentrated. In 2006, the SEC certified only five companies as nationally recognized statistical rating organizations. Just two of the five held 80 percent of the market by revenue and 99 percent of publicly traded debt and preferred stock. Subsequent efforts to encourage new entrants have not yielded results.
Reformers aim to increase competition by requiring all CROs to register with the SEC. Their premise is that there will be increased demand for CROs other than the “big three” if they all have the same government seal of approval. Registration, however, does not guarantee price and quality competition, and empirical research suggests it will not improve the accuracy of ratings. Furthermore, the regulatory burden imposed on registered CROs may make this provision harmful to small organizations with limited resources to spend on compliance.
Reducing Conflicts of Interest
The SEC’s 2008 investigation highlighted two major conflicts of interest: First, issuers, who seek the highest possible ratings, pay CROs to rate them. Second, CROs sell advice on structuring products before rating those products.
Research has shown that the first conflict could cause some issuers to pressure CROs for inflated ratings that would make the issuer’s products more attractive to investors. The SEC’s report found evidence of ratings shopping, for example. To make this conflict more transparent, one recommendation would require CROs to disclose the number of ratings an issuer and its affiliates pay for. It would also require CROs to disclose fees charged for the most recent rating and total fees charged over the previous two years.
Ensuring Adequate Internal Controls
The SEC found that CROs did not effectively implement systems to monitor their regulatory compliance. One way to address this problem is to require that CROs establish procedures to ensure compliance. They would also have to designate a compliance officer who would take primary responsibility for implementing systems of internal controls, due diligence, methodology, and ratings surveillance.
Naturally, it is difficult to predict the effects any reform will have on CROs and the credit ratings market. However, it is essential to address the problems identified by the SEC and scholarly critics of CROs. Legislation itself need not address every problem. If regulators have rule writing authority, they can use flexibility and creativity to keep recent history from repeating itself.